Morningstar - Q1 2023 - 10

Dispatches
When Inflation
Surfaced, TIPS Flopped
They became a bargain,
with an asterisk.
IVORY TOWERS
John Rekenthaler
When Treasury Inflation-Protected Securities
debuted in 1997, professional investors
immediately took them seriously. TIPS received
$31 billion during their first full year of
operation, while the mom-and-pop counterparts
to TIPS, Series I savings bonds (also known
as I Bonds, or inflation bonds), attracted a mere
$360 million when introduced. Last year, the
Treasury issued $186 billion worth of TIPS,
thereby pushing the outstanding balance of
TIPS to almost $2 trillion-5 times more
than bitcoin and twice the size of the entire
cryptocurrency marketplace.
In other words, TIPS have become a big deal. And
why not? Before TIPS, there were no securities
TIPS have become fixtures in portfolios created
by sophisticated financial advisors, as well
as in many leading mutual funds. For example,
American Funds Bond Fund of America ABNDX
holds more than 10% of its assets in TIPS,
as do Vanguard Target Retirement 2020 VTWNX
and T. Rowe Price Retirement 2020 TRRBX
funds. As suggested by the latter two funds,
investment professionals most commonly use TIPS
for retirees. Over enough time, the thinking
goes, stocks will overcome inflation, but retirees
cannot afford such patience. They need a
safeguard that works quickly.
Inflation Arrives
Until very recently, TIPS' insurance policy
went unused. For the 24 years from January 1997
through January 2021, the annualized rate
of increase in the CPI was a mere 2.09%. For all
designed specifically to combat inflation. Investors
could cobble together accidental inflation
hedges, such as gold, energy stocks, or perhaps
real estate-assets that might peripherally
benefit from higher prices or at least suffer less
damage than mainstream securities, but that were
not directly connected to changes in the
Consumer Price Index. TIPS are. When the CPI
rises, the Treasury raises the principal value
of all TIPS by that amount.
practical purposes, inflation was not an investment
danger. Holding 30-day Treasury bills would
have nearly matched the inflation rate, earning an
annualized 1.99%, and owning anything even
slightly bolder would have exceeded it. TIPS were
useful in theory but unnecessary in practice.
Then came inflation's resurgence, in spring
2021. The financial markets were initially skeptical
that inflation would persist; despite the CPI's
spike, stocks maintained their rally through the
remainder of 2021, while bonds held their
own. In fact, the yield on a conventional 10-year
Treasury note was lower on Dec. 31, 2021,
than it was on April 12 of that year, which was
the day before the Department of Labor
announced the first of what would be many
inflation shocks.
Everything changed in 2022. In January, both
stock and bond prices plummeted,
suffering a tandem decline that continues to
this day. The reason: inflation that has far
exceeded economists' expectations, leading
the Federal Reserve to hike interest rates much
more sharply than expected. At long last,
TIPS would have their moment! Their inflation
protection would now show its value.
Not hardly. TIPS have performed disastrously,
barely outdoing the traditional Treasuries
they were designed to thrash, should inflation
appear ( EXHIBIT 1 ).
EXHIBIT 1
Birds of a Feather TIPS barely outperformed traditional Treasuries in 2022.
0%
-9
-6
-3
-12
-15
1-5 Years
Source: Morningstar Indexes. Data as of Oct. 31, 2022.
-4.18
-6.50
Treasuries
TIPS
What Happened?
The return on bonds can be decomposed into two
components: the inflation rate, and that which
remains, called the real yield. With a conventional
bond, those two components are concealed,
because the security is priced by a single statistic,
its nominal yield. A bond that pays 4% may
expect 3% future inflation, thereby delivering a
1% real yield; or it may forecast 2% inflation,
with a 2% real yield. Any combination that sums
to 4% will explain that security's price.
-12.78
-14.48
5-10 Years
With TIPS, however, the figures are explicit.
Because all TIPS deliver exactly the inflation rate,
one can use TIPS' prices to compute their
real yields. The result reveals the popularity of
TIPS-the extent to which they are in fashion.
10
Morningstar Q1 2023
4%
Year-to-Date Return
https://www.morningstar.com/funds/xnas/abndx/quote https://www.morningstar.com/funds/xnas/vtwnx/quote https://www.morningstar.com/funds/xnas/trrbx/quote
Morningstar - Q1 2023

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